Knowing when and by what extent to change interest rates has never been an easy job for a Central Bank.
Today it is particularly hard. Labour markets are tight, and wages are growing, but at the same time, output growth is slowing, and a cost of living crisis envelopes the developed world because of galloping inflation.
What, for instance, to make of the oddity of 528,000 new jobs in the US in July, coming just a week after news that the US economy is in a technical recession after two consecutive quarters of shrinking GDP?
In this piece, we invite you to be on the Policy Committee of three major Central Banks and to consider a key issue specific to it that should inform how quickly, or not, the proverbial punch bowl of low-interest rates is removed from the US, UK and Euro Zone economies.
One might conclude that the role of a Central Banker is unenviable.
First, a general comment about the types of inflation facing the developed world. In the US, it is now primarily driven by labour shortages, leading to higher wages -particularly in the services sectors- and the risk of demand-led inflation, which can become very hard to squeeze out of an economy.
High energy prices and goods prices inflation caused by supply-side shocks has become less important.
In the Eurozone, energy prices dominate inflation concerns. There are some tight labour markets (e.g., in the tourism sectors in Mediterranean countries). Still, it is the Russian invasion of Ukraine, and its impact on oil and gas markets, that dominates the region’s inflation problem.
The UK is particularly badly affected: it suffers from both forms of inflation: supply side energy inflation and tight labour markets pushing up wages, and so risking a wages/ prices spiral.
A Central Bank’s policy for combating higher energy prices is very different from combating a tight labour market and the risk of excess demand. The first should be ignored since in the medium to long-term, high-energy prices are deflationary, in that they reduce the amount of discretionary spending elsewhere in the economy, and usually stabilise of their own accord eventually.
But, a tight labour market requires a Central Bank to raise interest rates to cool businesses’ demand for labour, and consumers’ appetite for foods and services (that require labour to produce).
Hence, the US Fed is much further ahead in its interest rate hike cycle than the European Central Bank (ECB), with the UK in the middle and why there is sympathy amongst Central Bankers for the Bank of England’s predicament.
In addition, the three Central Banks face specific challenges.
Fed rate hikes are intended to weaken the domestic demand component of inflation by creating slack in the labour market. The intention is that this will reduce vacancies and new hires, with limited damage to existing jobs. The result will be weaker demand growth, but with only a modest hit to employment, and the US will have a shallow downturn.
But Larry Summers -former US Treasury Secretary – is one of several high-profile economists who argues that raising interest rates will destroy those companies that are already weak, who will shed labour, and there is a real risk of a prolonged recession as a result.
In short, there is considerable debate as to whether the Fed -which has been slow to raise rates initially- is now in danger of over-doing it.
The Bank of England:
The UK Central Bank knows it must be seen to act on its forecasts of inflation rising to 13%, and so is raising rates. Even though high energy prices may well do the job of weakening demand alone. Hence it is forecasting the worst hit to real households since records began and five consecutive quarters of negative GDP growth.
Liz Truss, the current UK Foreign Secretary, is the front-runner to replace Boris Johnson as Prime Minister. She has criticised the Bank for not raising rates sooner and talks of reviewing its mandate.
Truss is campaigning on a policy of tax cuts to ease the impact of inflation on household earnings. This is an unorthodox fiscal policy to pursue when inflation is rising and may fuel inflation and lead to higher interest rates from the Central Bank than would otherwise have been needed.
How, and when should the Central Bank respond to challenges to its policy direction and to its independence? Pre-emptively, with much higher rate hikes? Or wait until the size, and the implementation date, of any tax cuts, are known? Or do nothing until the effect on domestic demand is known?
The ECB has decided that one-interest-rate-for-all creates undesirable, ‘asymmetric’, outcomes in the Eurozone. Because of a lack of investor confidence in Italy, commercial borrowing rates have risen much faster than they have in, say, Germany, in response to a relatively modest ECB interest rate hike.
Yet Italy, faced with structurally low growth, high unemployment and a large debt burden, probably requires lower borrowing costs.
How to respond? The ECB has created the Transmission Protection Investment’ Program (TPI), which will be used to buy Italian government bonds, and those of other struggling members, reducing the cost of commercial borrowing in Italy.
This is controversial since it breaks with a tradition that Member States’ bonds are bought by the ECB in a strict allocation reflecting the size of the country’s economies.
In addition, it takes the ECB deep into politics. For instance, the country whose bonds are being bought must demonstrate a sustainable debt reduction program and follow through on past commitments to secure EU and Eurozone funds. These are subjective evaluations.
If the euro project requires a political and fiscal union to ensure its long-term survival, then this is the path by which to get there. But, many Member States joined the Euro on the explicit promise that sharing a currency meant just -and only- that and nothing more.
The diversity of the three above problems illustrates the challenges facing Central Bankers. While they all try to pursue the difficult balancing act of ensuring stable prices and maintaining growth, internal theoretical, external political, and existential arguments also come into play.
Who would want to be a Central Banker?
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